There is a saying in weather forecasting: “Drought begets drought”. It relates to the inability of air masses to produce rain when there is little moisture in the ground due to an extended stretch of dry weather. Thus dry weather is itself a forcing mechanism for continued dry weather.

A similar process takes place in the stock market. It’s been a long time since there was a rainy day on Wall Street aside from a few nuisance showers, and this in itself is enough to help stave off future rainy days. After a string of up days, the market reverted back to Bull Market Stage 1 this past week – a relatively rare occurrence given that it has only occurred three other times in the past 10 years.

In the past, these reversions to previous market stages have been associated with short-term rallies that tended to last a few weeks before ultimately giving way to a significant sell-off. Of course past performance can never guarantee future results, but it is something to consider if the market breaks out to new highs again in the upcoming weeks.

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*All strategies involve at-the-money options opened 4 months (112 days) prior to this week’s expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY)

You Are Here – Bull Market Stage 1

Stage 1 is the “lottery fever” stage in which stock prices are being driven higher by the simple fact that stock prices have been on the rise recently. The lack of rainy days in the market begets a lack of rainy days. Stage 1 will continue this coming week (ending July 20) as long as the S&P remains above 1657.

If the S&P remains above 1657 this week, Long Straddle trading will remain profitable and Stage 1 will therefore continue.

If the S&P falls below 1657, Long Straddle trading will become unprofitable and Stage 2 – the “digesting gains” stage will begin.

If the S&P rises above 1720, Stage 1 will continue but Long Straddle trading profits will exceed 4% which is a signal that the market is “Due for a Correction”.

Lottery fever has its limits. Typically, in the past 10 years, once Long Straddle trading reaches profits of 4% or more during a Bull market, traders get spooked by their recent huge gains and begin selling in order to lock in some of those gains. Often a correction occurs within a week or so of that 4% level, but other times the market continues higher for one or two months before the correction begins.

If the S&P was to reach 1720 this coming week, that would mark 4% profits on Long Straddle trading, and thus would signal the possibility of an upcoming correction of 10% or so off of the highs.

The 1720 level is not out of the question. That is because the market never reached Stage 3 – the “resistance” stage, when it experienced the pullback in June. Generally, Stage 3 sets recent market highs in stone. Once Stage 3 is confirmed, those recent highs become brick-wall resistance. Since Stage 2 never progressed to Stage 3, but instead reverted to Stage 1, the recent highs are much less likely to act like a brick wall.

On the chart of “Stocks and Options at a Glance”, option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.

STEP 1: Are the Bulls in control of the market?

The performance of Covered Calls and Naked Puts (Category A+ trades) reveals whether the Bulls are in control. The Covered Call/Naked Put Index (CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

This week, Covered Call trading and Naked Put trading were both profitable, as they have been for an extended period. In fact, Covered Call trading became profitable in late 2011 and has remained profitable every week since then except for two very minor losses. That means the Bulls have been in control since late 2011 and remain in control today. As long as the S&P remains above 1525 over the upcoming week, the Bulls will retain control of the longer-term trend. The reasoning goes as follows:

• “If I can sell an at-the-money Covered Call or a Naked Put and make a profit, then prices have either been going up, or have not fallen significantly.” Either way, it’s a Bull market.

• “If I can’t collect enough of a premium on a Covered Call or Naked Put to earn a profit, it means prices are falling too fast. If implied volatility increases, as measured by indicators such as the VIX, the premiums I collect will increase as well. If the higher premiums are insufficient to offset my losses, the Bulls have lost control.” It’s a Bear market.

• “If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control.” It’s probably very near the end of a Bear market.

STEP 2: How strong are the Bulls?

The performance of Long Calls and Married Puts (Category B+ trades) reveals whether bullish traders’ confidence is strong or weak. The Long Call/Married Put Index (LCMPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

This week, Long Call trading and Married Put trading were both profitable, which is somewhat surprising as the trend for these types of trades has been clearly headed toward unprofitability. Although historically uncommon, the profits “bounced” almost exactly off of the line dividing profitability from unprofitability. Such a bounce is analogous to a second wind for the Bulls. It brings up a very real possibility that the Bulls may get a chance to retest the market’s recent record highs and possibly surpass them. As long as the S&P closes the upcoming week above 1613, the Bulls will retain confidence and strength. The reasoning goes as follows:

• “If I can pay the premium on an at-the-money Long Call or a Married Put and still manage to earn a profit, then prices have been going up – and going up quickly.” The Bulls are not just in control, they are also showing their strength.

• “If I pay the premium on a Long Call or a Married Put and fail to earn a profit, then prices have either gone down, or have not risen significantly.” Either way, if the Bulls are in control they are not showing their strength.

STEP 3: Have the Bulls or Bears overstepped their authority?

The performance of Long Straddles and Strangles (Category C+ trades) reveals whether traders feel the market is normal, has come too far and needs to correct, or has not moved far enough and needs to break out of its current range. The Long Straddle/Strangle Index (LSSI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

Long Straddle trading and Long Strangle trading became profitable on March 1, 2013. That marked the beginning of a surprising uptrend in stock prices. The profits continued uninterrupted for 16 weeks, the second longest winning streak in the past 10 years before finally returning to losses a few weeks ago, on June 22.

Long Straddle trading returned to profitability this past week; a relatively rare event given that either a correction on the order of 10% or so, or several months of sideways digestion often occurs between streaks of profitability for Long Straddles, neither of which was present this time. Although the data is scarce, such reversions have been associated with double tops in the past, and these short-lived rallies tended to end with a significant correction.

While the recent pullback in stock prices does not yet meet the criteria of a typical Bull market correction, it is quite possible that a correction may still occur. A level of the S&P above 1720 this coming week would push the LSSI over 4% signaling that the market was “Due for a Correction”. An elevated LSSI has always led to a correction in the past, and there’s no reason to suspect this time will be an exception. It’s just a matter of how long until it occurs. The reasoning goes as follows:

• “If I can pay the premium, not just on an at-the-money Call, but also on an at-the-money Put and still manage to earn a profit, then prices have not just been moving quickly, but at a rate that is surprisingly fast.” Profits warrant concern that a Bull market may be becoming over-bought or a Bear market may be becoming over-sold, but generally profits of less than 4% do not indicate an immediate threat of a correction.

• “If I can pay both premiums and earn a profit of more than 4%, then the pace of the trend has been ridiculous and unsustainable.” No matter how much strength the Bulls or Bears have, they have pushed the market too far, too fast, and it needs to correct, at least temporarily.

• “If I pay both premiums and suffer a loss of more than 6%, then the market has become remarkably trendless and range bound.” The stalemate between the Bulls and Bears has gone on far too long, and the market needs to break out of its current price range, either to a higher range or a lower one.

*Option position returns are extrapolated from historical data deemed reliable, but which cannot be guaranteed accurate. Not all strike prices and expiration dates may be available for trading, so actual returns may differ slightly from those calculated above.

Questions, comments and constructive criticism are always welcome. Enter them in the comment box below, or send them to OptionScientist@zentrader.ca.

The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”